Peter Pays Paul

I’ve written before about the government’s unintended consequences.

Today we read:

As we mentioned yesterday, a bit of a fight has broken out over whether it is irresponsible for journalists and others to advise homeowners about the options that the government’s bailout programs are opening up to them. But the fact is for a lot of homeowners it makes perfect sense to stop payments on mortgages…and it may even pay to stop any overtime work or have one of the earners in your household quit.

You Might Want To Think About Stopping Your Mortgage Payments and Reducing Your Income.

(HT:Tom Vanderwall)

Imagine that little retail center near your house.You know the one.

It has your favorite coffee shop, the weird home decor shop, a woman’s clothing boutique, the nail shop, and the national auto parts store.

Over the years you’ve seen the stores change. Different shop owners have come and gone. The coffee shop has been there for a while. The woman’s clothing store is only a year old.

As you drive by you notice a “Going Out of Business” sale going on in the home decor shop. You’ve talked with the owner of the woman’s boutique and she is having a rough time making a profit.

If these two stores close their doors, you wonder who is going to fill this space. What is going to happen to the owner of that little retail center? Where will he find tenants?

The Plight of Retail Stores

Americans are spending less money these days. We built our economy upon the model of consumption and borrowed to fuel that consumption.

With the well of cheap financing depleted, spending has come to a screeching halt. Retailers nationwide are taking a hit. The recent headlines have featured the likes of Circuit City, Mervyn’s, Shoe Pavilion, and Linens ‘n Things.

The Pain on Retail Center Owners

When a retail store closes or “goes dark” the landlord will feel the pain of having a vacant store. (Some leases do have a provision that stores can close but while the tenant continues to pay rent.) This means that she does not have as much rental income to pay the bills she faces for owning the property.

How Vacancy and Rental Rates Affect Value

I shared here the most common method to value income producing property. The most important numbers to determine value are Net Operating Income (NOI) and the Capitalization (Cap) Rate.

Rental rates and the assumed vacancy rate will affect the NOI. NOI is then used to calculate the value of the property based on an expected return to the investor, the Cap Rate.

Slight Changes with Devastating Effects

So how would a 10% decrease in rents, a 5% increase in vacancy, and a 1% increase in Cap Rate affect a properties value?

Notice that the value decreases by 26%.

Also notice that the change in the maximum loan amount decreases by $1.08 million. If the borrower needs to refinance under these new assumptions, the borrower will need to come up with over a $1 million to close the loan. The foreclosure process and bankruptcy are not far away.

The Current Credit Crisis

Currently, some institutional lenders have begun to underwrite retail loans along the lines of this scenario. They are forecasting decreasing rents and higher vacancy rates.

Some lenders are incorporating a higher cap rate as well. (One developer I know said that he hasn’t started a retail project unless it underwrote at a 8% cap rate or higher because of historical cap rates, even during the boom times.)

Unless, a retail property absolutely must be refinanced now, the wise real estate investor would be best served to hold off until cooler heads prevail.

The Wall Street Journal is reporting that Calpers, the California Public Employees’ Retirement System, has lost 35% of the value in its land and residential real estate investments.

As of August 31, 2008 the fund had a total of $233.4 Billion under management. Only 10.1% of that amount is allocated to real estate assets. The fund as of June 30, 2008 had lost only 2.4% overall.

The nation’s largest public pension fund, known as Calpers, is paying dearly for its ill-fated decision to become one of the most aggressive real-estate investors among public pensions.

Amid the rapid decline in the housing market, the value of Calpers’s investments in land and housing projects across the country had fallen 35%, to about $6 billion, as of June 30, according to recent performance results released Wednesday by the California Public Employees’; Retirement System.

The losses are likely to be larger now because the values were based on appraisals completed at the end of March. Since then, land values have cratered nationwide, as evidenced by the bankruptcy-protection filing of one high-profile Calpers undertaking, the LandSource land venture in California. An investment vehicle funded by Calpers sank $970 million in that venture, which holds 15,000 acres outside Los Angeles.

Calpers Confronts Huge Housing Losses – WSJ.com.

The NY Times has an interesting article on the California town of Mountain House that sprang up during the housing boom. The first homes were sold in 2003 and according to the article 90% are underwater on their mortgages.

Read the Article

The NY Times also has a map of the locations where homes are worth less than their mortgages.

Interactive Graphic – NYTimes.com.

No, I’m not writing about NASCAR or the IndyCar Series. And no it is not the video game.

I’m talking about those rare occasions where you need money and you need it fast.

If you are a commercial real estate sales agent or commercial loan broker, what do you do? Do you know who to turn to in a pinch?

In baseball many teams have the left-handed specialist who will come into the game to get one batter out.

Basketball teams have their specialists as well. The Chicago Bulls had Michael Jordan. The Lakers, Kobe Bryant. Who is your “Go-To-Guy” when time is short and you need a “sure thing”?

“Clutch”

Coaches depend on “clutch” players that will perform when the game is on the line.

Do you have a lender you can depend on when there are 10 seconds left and you are down by two? Do you have a “clutch” lender that understands real estate and can salvage a deal when your client’s deposit is on the line and close of escrow is days away?

Built for Speed

Most hard money lenders are built for speed. Some models of business are faster than others, but in general this is one of the advantages of hard money.

Because most private money lenders don’t have FDIC and state banking guidelines to follow they can underwrite and make a decision much faster than a bank. This allows them to fund deals much faster than a bank.

Always Be Prepared

No one plans on a deal going sour at the last minute, but it is good to have a plan for a “what if” scenario.

Like the Boy Scouts’ motto Be Prepared, commercial real estate specialists should have a tool for every situation. Having a relationship with a hard money lender for deals that require them is just another tool in the commercial real estate professional’s belt.

The Essence of a Professional

Which do you think sounds more reassuring to a client and more professional?

“I never have seen this situation happen before. I’m not sure what to tell you Mr. Borrower. I will have to get back to you on our options.”

Or

“Mrs. Borrower this situation rarely happens. However, I have developed a relationship with a lender that specializes in closing loans quickly. They are a more expensive than bank financing, but they will allow us time to find a more permanent solution.”

Quick Close Scenarios

Mr. O’Skool Mr. O'Skool is an experienced real estate investor. He is very "old school" and doesn't like much leverage. He speaks slowly and always has interesting anecdotes about life. He drives a late model station wagon and brags that he has a second matching station wagon at home in the garage. You are not sure you have seen him without a sweater on.

Mr. O'Skool owns a variety of properties He owns two apartment buildings free and clear. Through his network he learns that another apartment house is available for purchase. He knows that he can purchase it from the current owner if he closes in 15 days time at a 15% capitalization rate, otherwise the owner is going to list it on the market.

Can you get Mr. O'Skool the money he needs to purchase the property in 15 days?

Ms. Forshewnat

Ms. Forshewnat is a very successful real estate investor. She began with a few properties her late husband left to her and has parlayed that into a multi-million dollar real estate empire.

Through the grapevine you have heard that she is not extremely pleased with the service she has received from her previous lender. You have been courting her business for a while and she has finally agreed to allow you a chance at winning her business. She tells you that she is has other notes coming due in the coming months.

She has asked you to finance an office building she owns as the note is coming due in 120 days. You take Ms. Forshewnat to one of your lenders that has a great program for office buildings.

Everything is moving along without a hitch until the lender runs a new credit report 20 days before closing. It seems that Ms. Forshewnat co-signed a loan with her 23-year old son who has missed two of his payments. Now her credit score has dropped and the lender is unable to extend financing.

Can you find a lender to close in 20 days in order to keep Ms. Forshewnat from having a default and jeopardizing future loans?

Buying Time

In general, hard money is not a long-term solution. But it can buy you time to find that permanent solution.

Having a reliable, direct hard money lender can be invaluable to commercial real estate professionals.

Reuters is reporting that GMAC’s mortgage unit, ResCap, has reported its 8th straight quarterly loss of $1.91 billion. GMAC, LLC, the financing arm of GM, reported its 5th straight quarterly loss.

The unit speculates that GMAC may convert to a bank holding company in order to receive funds from the TARP.

This as well as the previous post do not bode well for the residential real estate recovering soon. Fewer lenders equals less competition. Less competition means higher interest rates. Fewer borrowers will qualify for loans at higher rates and fewer houses will be sold.

Long-term this is a good sign because it is the removal of inefficient competitors from the marketplace. It will also be beneficial because it will help with the deleveraging of the economy and it will force those of us in the market for a house to save or build equity the old fashioned way.

GMAC has $2.52 bln loss; ResCap unit may fail | Reuters.

(HT: Agent Genius News)

When governments intervene into private contracts it has long-term unintended consequences, and usually they are negative.

Read a blurb regarding the research from the St. Louis Fed on the downside of a moratorium on foreclosures.

Governments cause both immediate and long-term effects when they rewrite the terms of contracts between private parties, Wheelock argueded. “Although the economic and societal benefits of lower foreclosure rates are difficult to measure,” he said, “research shows that the foreclosure moratoria of the Great Depression imposed costs on future borrowers.”

Future borrowers were faced, according to the analysis and cited studies, with a restricted supply of loans and sky-high interest rates, because lenders needed to compensate for the possibility that their right to foreclose on delinquent loans would be constrained. Under the nation’s current turmoil, policymakers are scrambling to enact similar regulations as were made during the great depression, in order to limit the highest foreclosure rates since (what else?) the Great Depression.

Here is the link to the HousingWire.com article.
History Warns Against Foreclosure Moratoria: Study : HousingWire.

Here is a link to the St. Louis Fed report.

Update (HT: Tom Vanderwell)

The WSJ.com is reporting that the banking bailout is luring thousands of banks to apply for some of the $700 billion the government is handing out.

Why are the banks lining up for the funds?

Now institutions across the U.S. worry that if they don’t try for the money, the market will judge them as too unhealthy to qualify, or lacking the savvy to deploy cheap government capital on acquisitions and investments.

Is this what the government had in mind when they intervened in the banking system?

Rescue Cash Lures Thousands of Banks – WSJ.com.

Paul Kedrosky has an interesting graph from John Mauldin up in the link below that highlights the difference in the GDP if you were to subtract mortgage equity withdrawals.

Paul Kedrosky: Funny Money: U.S. GDP Growth Net of Mortgage Withdrawals.

What does this mean?

Much of the growth in the US economy from 2001 t0 2006 was fueled by money borrowed from our houses.

Now that home equity has disappeared for many homeowners, discretionary spending will decrease.

Companies that depend discretionary spending (retailers) will feel the pinch by the loss of this discretionary spending money.

(HT:Tom Vanderwell

The Wall Street Journal has another article on an East Bay town this week.

Antioch, California is the focus of an article by the Journal regarding IndyMac Federal Bank’s (formerly IndyMac Bancorp) efforts to stem the tide of foreclosures.

FDIC Plan Tests Limits of Leniency – WSJ.com.

The FDIC is taking steps to modify as many delinquent loans as possible. There are some complications with the process, including loans that IndyMac Federal Bank only provides the servicing for.

IndyMac sold many of the loans it made to various investors. IndyMac still services the loan by collecting payments, keeping track of interest owed, and filing the necessary tax forms. IndyMac is limited in its ability to negotiate with the borrower because it is no longer the lender, the investor that bought the loan is now owed.

I also liked the WSJ’s efforts to give an accurate description of those that had borrowed money from IndyMac. Some used loan proceeds to buy other houses. Others have stopped paying and have “socked away money he saved by not paying IndyMac” and stored it in a safe.

Not all delinquent borrowers are “down on their luck”.